The slow wheels of the legal system and the fast-moving nature of the tech sector are once again at odds with one another. By the time sensible regulations that do not restrict innovation or growth have been established, technologies have already evolved to a point that renders these inadequate or even obsolete. Cryptocurrencies, as anyone involved in the space will know, are no exception to this rule.
Now more than ever, clarity on cryptocurrency is sorely needed. With increased adoption by retail investors, institutional investors, and Big Tech companies, individuals and businesses must know where they stand with regard to tax liabilities – particularly since the burden rests entirely on them to report their earnings correctly.
The US has yet to deliver adequate guidance to these ends: taxpayers know that their holdings are to be treated as property for the purposes of taxation (as outlined in a 2014 document published by the IRS), but that’s about it. The rest is guesswork, and there are a handful of technological considerations that often leave investors/traders in the dark when attempting to reconcile cryptocurrencies with what we traditionally perceive to be ‘property’.
Unlike other forms of property, cryptocurrency is prone to hard forks – a concept that’s been discussed since Bitcoin’s inception, but one that has only been witnessed at a significant level in the past few years, with a number of high-profile splits resulting in the creation of new cryptocurrencies.
In essence, a cryptocurrency forks when software rules have been modified, making the new software incompatible with nodes (servers) that have not been updated. However, any private keys holding an amount of the original coin will find themselves holding an equal amount of the newly-created one. Examples of this include the Ethereum/Ethereum Classic split, the Bitcoin/Bitcoin Cash split, and the subsequent Bitcoin Cash/BitcoinSV split.
What this means for a holder is that they end up with their quantity of cryptocurrency doubling, without any way to opt-out. This raises a very important question: how is cost-basis calculated on the forked coin? It may initially make sense to assign it to the dollar value of the original coin, though given that the forked coin is essentially received for free (and that value of these has historically never matched that of the original), this approach does not seem correct. Forks are created because a group of users decides the value of the original coin can be enhanced by changing it in some fundamental way. This reality alone should be enough to value the new coin differently for cost basis.
A more logical approach would be to regard the forked coin for what it is – an option that, if disposed of, results in a gain for the holder. As such, setting the cost basis to $0 would see the entirety of the value assessed as a gain, ensuring that the individual still profits and that the government still gets its cut.
The best method for accounting is also something many investors would like to see the IRS elaborate on – the approach used varies per person. When it comes to property, specific identification (SI) is undeniably the gold standard, as it enables the taxpayer to strategically dispose of units of an asset so as to control the offset gains over time. For large inventories, however, this method can become unwieldy and some form of automation is required. Doing so manually with cryptocurrency is difficult, as each unspent transaction output must be tracked from acquisition through to disposal.
Many opt instead to use First In, First Out (FIFO) to calculate their taxes. Whilst not as flexible as SI (it cannot be used to minimize dues), it follows the simple assumption that the oldest unit held is that being disposed of, making it comparatively easier to manage. Based on historical rulings, the IRS favors SI and looks to the intent of a trade as a heuristic, as opposed to the complications associated with calculating gains. It remains to be seen which they will advise.
As is the case seemingly every year, cryptocurrency enthusiasts await new guidance from the IRS. Such is the severity of the situation that even members of Congress and representatives of the AICPA have demanded that the agency take action. According to the IRS’ latest communication, there would be guidance issued ‘soon’, though no timeframe has explicitly been established, though there was a hint back in May that guidance could come within 30 days, at the time of writing we still are waiting.
In the meantime, the most prudent move for taxpayers is to continue to record every one of their cryptocurrency transactions so as to maintain an audit trail, which can then be presented to experts to figure out how to best calculate tax liabilities.
DISCLAIMER: This article expresses my own ideas and opinions. Any information I have shared are from sources that I believe to be reliable and accurate. I did not receive any financial compensation for writing this post, nor do I own any shares in any company I’ve mentioned. I encourage any reader to do their own diligent research first before making any investment decisions.